Looking at Corporate Governance from the Investor's Perspective

• Publication year: 2014

Looking at Corporate Governance from the Investor's Perspective

Luis A. Aguilar

LOOKING AT CORPORATE GOVERNANCE FROM THE INVESTOR'S PERSPECTIVE

Luis A. Aguilar^*

Introduction

Thank you for inviting me to speak in connection with the launch of Emory Law School's newest journal, the Emory Corporate Governance and Accountability Review. Before I begin my remarks, let me issue the standard disclaimer that the views I express today are my own, and do not necessarily reflect the views of the U.S. Securities and Exchange Commission ("SEC" or "Commission"), my fellow Commissioners, or members of the Commission's staff.

Corporate governance has always been an important topic. It is even more so today, as many Americans recognize the need to develop a more robust corporate governance regime in the aftermath of the deepest financial crisis since the Great Depression.

Although the recent financial crisis—aptly named the "Great Recession"— has many fathers, there is ample evidence that poor corporate governance, including weak risk management standards at many financial institutions, contributed to the devastation wrought by the crisis.¹ For example, it has been reported that senior executives at both AIG and Merrill Lynch tried to warn their respective management teams of excessive exposure to subprime mortgages, but were rebuffed or ignored.² These and other failures of oversight

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continue to remind us that good corporate governance is essential to the stability of our capital markets and our economy, as well as the protection of investors.

Unfortunately, the important lessons of the recent past have been quickly forgotten. For many, the Great Recession, which began in late 2007, is already in the rearview mirror.³ Last month, the S&P 500® hit record highs,⁴ while Wall Street bonuses reached their highest levels since the 2008 crash.⁵ In addition, recent reports suggest that retail investors are beginning to return in volume to the stock market.⁶

All of this has taken place even though other reports suggest that there is only tepid confidence in the actual recovery.⁷ Many Americans continue to lack trust not only in the stock market, but also in financial institutions and the U.S. economy. According to researchers at the University of Chicago, trust in America's financial system languishes at about the 24 percent level, with many expressing continued concerns regarding both excessive compensation and a lack of integrity among top corporate managers.⁸ Only 17 percent of those surveyed expressed trust in America's large corporations.⁹ This is a serious issue, because trust is fundamental to both trade and investment. When there is a lack of trust, both Wall Street and Main Street suffer.¹⁰

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So, how can trust be restored? I believe that a key driver of greater trust is the oversight that comes from robust corporate governance.¹¹ This is one reason why the work of the new Emory Corporate Governance and Accountability Review will be so important.

I. Investors as Owners and the Source of Capital

As you embark on the study of corporate governance, I urge you to look at the issues involved from the investor's perspective. I firmly believe that an approach that focuses on investors is central to developing an effective corporate governance framework. It is, after all, investors that provide the capital that businesses need to grow, compete, succeed, and create jobs. They are, in a very real way, the fuel that keeps the engine of our economy moving.

Investors, of course, are not limited to the so-called "one percent." In fact, the vast majority of investors make their livings on Main Street, not Wall Street. They are school teachers and sanitation workers, factory workers and first responders—indeed, anyone with a mutual fund, a pension fund, or a 401(k) plan. About half of all U.S. households participate, either directly or indirectly, in the stock market; and while that percentage is far less than it was during the boom years prior to the financial crisis, it remains true that millions of households invest in stocks, bonds, and mutual funds in order to save for retirement, to put together a down payment on a house, or to pay for their children's college—and law school—education.¹² These hardworking Main Street Americans are the investors that need to be kept in mind as we think about corporate governance.

So, what does corporate governance mean for investors? Simply this: it means that the owners of the company are those who have paid to own the company's stock, and that management are merely their employees—albeit often well-paid employees. The separation of ownership and control is the hallmark of the modern corporation. It would be neither possible nor desirable for the many, widely-dispersed shareholders of any public company to come together and manage that company's business and affairs. As a result, full-time management is essential for public companies to operate, and any investor will tell you that talented management is extremely valuable.

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But even the most capable management, left unchecked, can make bad decisions, leading to undesirable results for a company and its shareholders.¹³ That is why shareholders elect a board of directors to represent their interests.¹⁴ Good corporate governance helps shareholders and their representatives to hire the right managers, and helps make sure that the managers remember they ultimately answer to shareholders. Additionally, good corporate governance also helps to remind the company's directors that they work for the company's shareholders, not for themselves, and certainly not for management.

This is not a new concept. The question of how to make management accountable to shareholders has been around since the modern public corporation was invented.¹⁵ The duties of loyalty and due care that govern the conduct of corporate directors have their roots in English common law¹⁶ and have been developed by a century and a half of jurisprudence in Delaware chancery and other state courts.¹⁷ But it is not enough to simply state what the duties are: the exercise of these duties requires the development of a corporate culture, as well as specific processes and practices that promote the fundamental principles of corporate governance.

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To that end, I would like to focus on three fundamental principles that should drive the establishment of an effective corporate governance regime— accountability, transparency, and engagement. Rather than discuss these principles in the abstract, I will examine them in the context of the executive compensation process. In addition, I will highlight just a few of the ways in which the SEC incorporates these important principles in its rulemaking and enforcement programs.

II. Accountability

It is particularly fitting that the name of Emory Law School's new journal—the Emory Corporate Governance and Accountability Review— makes it clear that accountability is central to effective corporate governance.

Accountability means that actions have consequences. When corporate governance embodies the principle of accountability, shareholders know that performance will be measured. They know that good performance will be rewarded, and poor performance will not. And, most importantly, they know that misconduct will not be tolerated.

A. Executive Compensation

One important measure of accountability involves executive compensation. common sense would indicate that good corporate governance should align compensation with performance. However, recent history has to make you wonder if the principle of accountability is lacking in today's corporate governance.

It is well known that the last thirty years have seen rapid growth in the compensation of corporate executives.¹⁸ Much of that growth reflects the trend towards equity-based and other incentive compensation. This form of pay is intended to align the interests of public company shareholders and corporate managers. The concept is straightforward: When stock prices rise, shareholders benefit and managers share in the wealth through stock options, appreciation rights, and other awards. In essence, when the companies do well, so do executives. During the boom years, executive pay soared.

But a strange thing has been happening: many executives have been enjoying the benefits of the pay-for-performance boom, without necessarily

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delivering increased performance. In fact, the development of the golden parachute has often meant that, in practice, executives have been rewarded handsomely for failure.¹⁹ To give just a few examples, in 2006, Viacom gave roughly $85 million in severance pay to its then CEO after just nine months in the top job.²⁰ The former CEO of CVS received a severance package worth $185 million when he left in early 2011, even though his company's net earnings had declined the prior year.²¹ And last week it was reported that the former chief operating officer of Yahoo!, who was fired earlier this year, received about $96 million in compensation for his fifteen months on the job, including about $58 million in severance payments.²² Many other top executives have been shown the door with seven- and eight-figure severance payments. As many commenters have observed, safety nets of these sizes undermine management incentives from the moment they are granted.²³ When even failure can vastly increase your wealth, you don't need to worry about working hard to be successful. Nor do you need to worry about being accountable.

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B. Say on Pay

One important way to enhance accountability is to make sure that shareholders are able to express their views. In 2010, Congress took steps to address this concern in the context of executive compensation, by requiring public companies to give shareholders a voice through so-called "say-on-pay" votes. Specifically, Section 951 of the Dodd-Frank Act²⁴ requires public companies to conduct shareholder advisory votes to approve the compensation...